The Australian economy is continuing to benefit from favourable international conditions.
The global expansion is proceeding at a strong pace and is broadly based across
the world's main economic regions. Growth in the United States economy
is now showing further strength after a temporary dip late last year. In Japan
the indications are that the recovery is gathering momentum, and there are
encouraging signs that the economy has emerged from the debt-deflation spiral
of the past decade or more. In China and other parts of Asia the already rapid
pace of growth appears to have picked up further recently. Overall, the world
economy is likely to expand at a faster-than-average pace in 2006 for the fourth
successive year, and most observers expect this to continue in 2007.

The strong global expansion in recent years has been accompanied by sustained upward
pressure on a range of international commodity prices. An important aspect
of this has been the rise in world oil prices. Concerns about possible supply
disruptions have at times contributed to these oil price fluctuations, but
for the most part the upward trend has been a consequence of strong global
demand. As a result, expectations of world growth have generally remained strong
throughout the period when oil prices have been rising.

More generally, the strength of the world economy over recent years has underpinned
substantial increases in a wide range of other commodity prices in the resources
sector. As a major resources exporter, Australia is one of the countries that
most benefits from these developments. Over the past three years, Australia's
terms of trade have increased by more than 30 per cent, and this has had a
significant expansionary effect on domestic incomes and spending. Recent indications
are that the upward pressure on world commodity prices has continued. Prices
of the base metals included in Australia's commodity price index have
increased by an average of more than 50 per cent over the past year, building
on the already large increases that had occurred over previous years. At the
same time, indications from the current contract negotiations for Australia's
coal and iron ore exports are that prices of these bulk commodities in aggregate
will remain close to record highs.

Against the background of the strong global economic expansion, interest rates in
the major economies have been increasing. Most of the major central banks are
now in the process of normalising their official interest rates from the unusually
low levels that they reached earlier in the decade. In addition, long-term
market rates have been rising recently in response to the continuing strong
economic news. In Australia, market interest rates have also been increasing,
in response to a combination of strong global economic trends and firmer domestic
data. Market interest rates moved upwards across the yield curve in Australia
during the recent period such that, by the time of the May Board meeting, the
market was fully pricing in a rise in the cash rate in the coming months, with
a 50 per cent probability that it would occur at the May meeting itself. Also
noteworthy has been the buoyancy of the Australian share market. Australian
share prices have increased by 11 per cent since the start of the year, outperforming
the main share markets overseas.

The Australian economy has been operating for some time with rather limited spare
capacity. During the course of a sustained expansion, now in its fifteenth
year, Australia's unemployment rate has been substantially reduced, and
unused productive capacity re-employed. The unemployment rate has been broadly
steady over the past year at an average of just over 5 per cent, its lowest
since the 1970s. Business surveys and liaison reports continue to indicate
that labour market conditions are tight and that the economy as a whole is
operating at a high level of capacity utilisation. Businesses have been reporting
that lack of suitable labour was a bigger constraint on their activities than
more traditional concerns about the adequacy of demand or sales.

Growth of the Australian economy over the past couple of years has been influenced
by a combination of factors including strong commodity prices, which are contributing
to a favourable climate for business investment, and a process of balance-sheet
adjustment taking place within the household sector, which has been constraining
consumption. As a result, the economy has undergone a marked shift in the composition
of growth, with the overall growth in demand now being mainly driven by business
investment rather than household spending. Since the middle of 2002, business
investment has increased at an average annual rate of 14 per cent. Investment
in the resources sector has been the fastest growing component, but the growth
has been broadly based across industries. Although some easing from these unusually
high growth rates can be expected, prospects for expansion in business investment
remain favourable. Strong profitability and rising share prices are indicative
of good business conditions, confidence in most sectors is high, and the recent
further increases in a range of commodity prices will provide continued stimulus
to the resources sector.

The boom in business investment has been accompanied by a slowing in household spending,
which helped to contain the overall growth in domestic demand. Consumption
growth peaked around the end of 2003 and has since slowed to a little below
trend, mainly reflecting a period of balance-sheet adjustment in which households
have shown a reduced appetite for additional debt. Nevertheless there are some
signs that consumer spending may be starting to pick up. Notwithstanding higher
petrol prices, retail sales have been stronger over the past three months and
consumer sentiment has been above average. Employment has picked up recently,
which should support household incomes.

Australia's export performance over recent years has been disappointing, considering
the favourable international conditions. While export earnings have increased
substantially, this has to date been mainly a result of higher prices rather
than growth in volumes. Nevertheless, there are some early signs that volume
growth in resource exports is beginning to pick up, flowing from the substantial
investment undertaken in that sector in recent years.

The net effect of these factors is that domestic demand has continued to grow at
a solid pace over the past couple of years, though down from the unsustainably
high rates seen earlier in the decade. GDP growth has been below trend recently
but appears likely to pick up, given the continued growth in domestic spending,
the stimulus from Australia's rising terms of trade, and the likelihood
of a recovery in export volumes. Overall, the Bank's assessment is that
demand and output growth over the next year or two are likely to converge to
a pace broadly in line with the growth of the economy's productive capacity.
This outlook implies that the economy will continue operating at a relatively
high level of capacity utilisation, although strong business investment will
undoubtedly contribute to capacity expansion over time.

Recent trends in credit growth indicate that households and businesses have continued
to find it attractive to borrow at prevailing interest rates. After touching
a low point in the September quarter, the growth of household credit has picked
up over the two most recent quarters. Business credit growth has continued
to trend upwards. A factor that is likely to have contributed to the overall
strength of credit growth has been the continuing compression of lending margins
by financial intermediaries over recent years, reflecting competition among
lenders. As a consequence, although the cash rate has been close to its historical
average, interest rates paid by borrowers have remained below average.

The combination of strong global conditions, tight capacity and solid demand growth
in the domestic economy has added to inflationary pressures. Wages growth,
though not accelerating further recently, is higher than it was a year ago.
Producer price indices continued to rise quickly in the March quarter, reflecting
the general strength in international commodity prices. Consumer price inflation
has to date been well contained but in the March quarter was higher than expected,
with the CPI rising by 0.9 per cent in the quarter and by 3.0 per cent over
the year. The latest quarterly figure was boosted by seasonal factors (health
and education costs) while petrol price increases contributed significantly
to the annual figure. Abstracting from the influence of extreme movements in
individual prices, underlying CPI inflation is estimated to have risen to around
2¾ per cent, a rate it had not been expected to reach until the second
half of the year.

The Bank's assessment of the outlook as presented in the February Statement was that underlying inflation would increase only modestly
and would most likely level out at a rate of 2¾ per cent. This forecast
reflected the upward pressure on inflation stemming from the pick-up in labour
and materials costs, while recognising that global disinflationary forces would
help to contain prices in the tradables sector. In reviewing the outlook to
incorporate the March quarter inflation data and other domestic and international
news, the Bank's assessment was that, other things equal, the medium-term
inflation risks were increasing. However, taking into account the expected
dampening effect of the May policy tightening, the forecast for underlying
inflation is broadly unchanged at 2¾ per cent. In the short term, headline
CPI inflation can be expected to be noticeably higher than that figure, as
recent increases in fuel prices are recorded in the index in the next quarter.

In summary, the economic situation reviewed by the Board has for some time been one
in which international conditions have been favourable to growth in Australia,
the economy has been operating with limited spare capacity, and underlying
inflation has been forecast to increase gradually. In these circumstances,
the Board had taken the view that the next move in interest rates was more
likely to be up than down, and this was signalled in the Bank's policy
statements.

The Board's judgment at its May meeting was that the flow of recent information
strengthened the case for an increase in the cash rate. International data
continued to suggest strong prospects for the global economy, with forecasts
having recently been revised upwards. Domestic indicators were consistent with
a solid outlook for demand and activity, while credit growth was strengthening
and local equity markets had been buoyant. While underlying inflation had generally
been quite stable over the previous couple of years, there were a number of
signs that the prevailing conditions were starting to add to inflationary pressures.

Taking account of this information, the Board's assessment was that inflationary
risks had increased sufficiently to warrant an increase in the cash rate. The
Board will continue to monitor developments and make such adjustments as required
to promote sustainable growth of the economy with low inflation.